WASHINGTON -- Two bank regulatory agencies have told banks and thrifts to avoid inverse floaters and other structured notes unless they fully understand their potential risks under a wide variety of market conditions.
The Federal Reserve Board, in a recent supervisory letter to member banks and examiners, said structured notes may be "inappropriate" for "many depository institutions" because they "can expose investors to significant losses as interest rates, foreign exchange rates, and other market indices change."
The Treasury's Office of Thrift Supervision, in a bulletin sent yesterday to savings associations, said that structured notes may be "inappropriate for unsophisticated investors" because of their complexity.
The warnings are similar to those made by the Office of the Comptroller of the Currency last month in guidelines it issued for national banks.
Structured notes, many of which are issued by U.S. government agencies and other entities with high credit ratings, are debt securities whose cash flows are dependent on one or more indexes in ways that create the risk characteristics of forwards or options, the Fed said in its letter.
These notes reflect a wide variety of cash-flow characteristics and can be tailored to the needs of individual investors. The products provide investors with certain benefits. They can be used to reduce counterparty credit risk, to create operating efficiencies, and to lower transactions costs.
But structured notes also may have characteristics that cause them to be risky for investors, the Fed said. They may have substantial price sensitivity, for example, or they can be complex and difficult to evaluate. They may also involve leveraging, the Fed said.
Their customized features and embedded options may make them difficult to price and can reduce their liquidity, the Fed said.
Both the Fed and the OTS said banks and thrifts, before buying these instruments, should consider whether they are consistent with their investment policies and portfolio strategies. They should also thoroughly understand these instruments and their potential risks under a wide range of market conditions.
"The critical factor for examiners to consider is the ability of management to understand the risks inherent in these instruments and to manage the market risks of their institution in a satisfactory manner," the Fed said in its letter.
The Fed urged its examiners to evaluate the appropriateness of these securities on a bank-by-bank basis.
These evaluations should include a review of the bank's ability to conduct stress tests, which evaluate risks under various market conditions, the Fed said.
The Fed worried that some banks, in deciding whether to invest in these instruments, may focus only on low credit risk and favorable yields and will overlook or underestimate the market and liquidity risks. Examiners should discuss these issues with the banks, the Fed said.
"Failure of management to understand adequately the dimensions of the risks in these and similar financial products can constitute an unsafe and unsound practice for banks," the Fed said.
The lists of products targeted for concern by the two agencies included inverse floaters, single- or multi-index floaters, dual index notes, index-amortizing notes, step-up bonds, range bonds, and deleveraged bonds.
